Brainstorming Session on Fair Value Research

In our next session of office hours (Tue, June 16th, 4pm ET), we will have our second brainstorming session.

For those of you who couldn’t make the first brainstorming session, Bob Lipe led us in a discussion of research ideas related to leasing. As in any good brainstorming session, Bob wasn’t just giving away research ideas, but I for one came away with a research idea that I’m going to pursue with one of the other session participants. I’m sure others did as well!

This time, I will lead a discussion on topics related to fair value. In my opinion, proponents and critics of fair value have had much to say recently about fair values. In Tuesday’s session, we will consider some recent assertions that have been made (e.g., by Board members, academic researchers, and others). My intent is to ask whether these assertions have existing empirical support and, if not, discuss how various methodologies might be brought to bear on each topic.

To provide some structure for our discussion, I have put together a list of questions and background reading. My hope is that each participant will have a special interest in one or two of the questions and so spend more time thinking about those items. That way, we will (hopefully) have several people willing to jump in with thoughts/ideas on each topic.

Feel free to add a comment if you have additional thoughts or references that might be helpful in preparation for Tuesday.

Market prices are influenced by many factors: expected cash flows, the time value of money, risk, market participants’ attitudes toward TVM and risk, investors’ capital flows and liquidity needs, etc. In theory, which of these factors should fair value capture? In practice, what factors are (or do preparers/users believe should be) captured in fair value measurements? Do these answers differ for level 1, 2, 3 measurements?

One of the biggest concerns with fair value measurements is that fair value is procyclical and that it has contributed (or even caused) the current credit crisis. While academic research has identified various potential feedback mechanisms, each mechanism requires some assumptions about the way in which regulators, investors, and/or managers will behave. Is there empirical evidence that these (or other) fair value feedback loops have caused any major firms to go under? How would one go about testing these theories (broadly) or specifically their role in the current credit crisis?

Suggested background reading: For potential mechanisms, see notes on Haresh Sapra’s presentation in office hours on fair value here and see also Bloomfield, Nelson, and Smith (2006); For arguments against the role of fair value in the credit crisis, see sections B and C (pgs. 8-14) of Hunt (2009).

Q3) In bear markets, how do investors respond to fair values?

One type of feedback mechanism work like this: As the market value of a firm’s assets decline, fair values cause firms to report losses. As these firms see a decline in the strength of their balance sheets, they are forced to sell some of the assets with declining values, which sets off a new round of write-offs. Related to this, there seems to be some concern that, as fair value losses get racked up, liquidity will dry up and prices will spiral downward. However, others (including some Board members) have argued that fair values facilitate identification of risk and valuation and so facilitate market liquidity. Is there evidence on this issue?

When risk aversion changes and investors rebalance their portfolios, the ensuing flight to quality can alter market prices, even though the underlying fundamentals haven’t changed. Is this what we want captured in financial reports? Do users understand when this happening?

On a related note, the FASB recently issued an FSP requiring firms to separate their losses on non-trading, debt securities into their credit and non-credit portions. Can preparers separate these two risks? How do users interpret the separation? (e.g., do they differentially price the credit losses? is the differential stronger for HTM securities?)

Q5) Is there role for what Larry Smith calls “activity based measurement”, meaning differential accounting based on how management uses (or intends to use) an asset? What changes when management plans to hold a security to maturity? In a similar vein, Leslie Seidman has talked about using a three-dimensional matrix to categorize financial instruments when thinking about whether fair value is an appropriate measurement attribute.

Extending a little more along this line of activity based measurement, should accounting standards anticipate how their standards will be used? And should this inform standard setter’s choices (such as when deciding between fair value and amortized historical cost)? To what extent should standard setters be neutral or conservative when issuing rules?

For thoughts on the conceptual framework and anticipatory standards, see this post.

Jeffrey Hales

Jeffrey Hales is an associate professor at the Georgia Institute of Technology, where he teaches financial accounting. He conducts research on investor and analyst decision making, using techniques from applied game theory, experimental economics, and psychology. During the 2009-10 academic year, he was the Financial Accounting Standards Board's Research Fellow.

Tomorrow’s Fair Value discussion is a must for any financial reporting researcher. Lots of ideas. I hope to see you there. I’ll be there to tell you, if you are interested, to tell you about 2 working papers I have on the topic – one with Cathy Shakespeare and Karen Nelson — and one with Kathryn Kadous and Jane Thayer.

Here is the abstract of the first paper:

ABSTRACT: For some time, a debate has existed on the relevance of fair value versus historical cost for the valuation of financial instruments. In this study, we conduct three experiments to test the idea that investors’ views about fair value are contingent (that is, investors are not either “fair value” or “historical cost” supporters), depending on whether the item in question is an asset or liability and the situation being evaluated. Results are supportive of our predictions and also indicate that investors use a non-diagnostic “ease of acquiring or selling” heuristic to judge the relevance of fair value. Our results also reveal that attempts to debias investors’ judgments by providing them with the economic intuition does work, although it may lead to unintended effects. Implications for standard setters and investors are provided.

I agree with Dr. Koonce that there are many research ideas that can be pursued by accounting researchers in the area of fair value. As a behavioral audit PhD student, I find the recent FASB project on SFAS 157 interesting. As Dr. Bloomfield has pointed out that there are much discussion among standard setters and academic researchers on fair value, I thought it may be fruit to consider/brainstorm the implications of fair value on the auditing profession.

In September 2006, the FASB issued the Statement of Financial Accounting Standard (SFAS) No. 157 for fair value measurements text to be clickable . My understanding of the objective of SFAS 157 is that it establishes a framework to specify how fair value should be measured in accordance to GAAP. Specifically, SFAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (p. FAS157–6). SFAS 157 outlines three valuation approaches (market approach, income approach, and/or cost approach) and three input-levels. Level 1-inputs represent unadjusted quoted market prices, Level 2-inputs represent other observable prices, and Level 3-inputs represent unobservable prices (p. FAS157–41 – 43). I believe that SFAS 157 signifies a change in our current rules-based accounting standards to the principle-based accounting standards. I think this change will have a significant impact on the auditing profession.

Financial statements auditors have often been criticized for having a check-box mentality. In 2006, Cheryl K. Tjon-Hing text to be clickable , valuation specialists from the SEC, expressed concerns about auditors’ ability to audit fair value measurements. In addition, in response to the fair value accounting standard, the PCAOB released a staff audit practice alert text to be clickable in December 2007 to remind auditors of the potential increase in audit risk and their responsibilities related to fair value financial statements audit. When I attended the 2008 Audit Midyear meeting, I remembered Dr. Katherine Schipper suggested that the characteristics of fair value measurements in SFAS 157 placed certain demands on auditor expertise. She said that SFAS 157 has created a new dimension of measurement complexity rather than accounting complexity for the financial statements auditors. For example, auditors may need to obtain modeling expertise to evaluate management’s fair value measurements on contingent claims asset pricing if the fair value inputs are not based on readily observable prices. Moreover, auditors will need to have sufficient knowledge of markets and market conditions to evaluate the appropriateness of management’s classification of fair value measurements.

Such an increase emphasis on professional judgment about fair value measurement complexity will require auditors to obtain the necessary measurement expertise to make appropriate fair value audit assessments. However, Dr. Schipper has observed that auditors are not receiving sufficient training from their accounting education programs to develop the measurement expertise needed to make these proper valuations . I think there are research opportunities for researchers to find ways to improve auditors’ consideration of fair value in a financial statements audit.

I hope to participate in today session, but I am not sure if my machine can get on Second Life. If I am not able to attend the session, here is my idea that may be of interest to some of you. As Dr. Schipper has mentioned that auditors lack the necessary training in measuring fair value, I think it may be fruitful for researchers to develop decision tools that will improve auditors’ performance in fair value auditing. For example, Rose et al. (2009) find that financial statement auditors who adapted the fraud experts’ knowledge structure are more accurate in their fraud risk assessment . Perhaps accounting researchers can examine the possibility of developing fair value auditing decision tools that are based on the knowledge structure possessed by the fair value specialists.

Thanks for this comment, Lawrence. You reminded me of something that Katherine Schipper said about fair value measurements in her 2005 piece in the European Accounting Review. In the quote below, she talks about the research opportunities and educational challenges that intentional bias and lack of expertise in estimating fair value present to our discipline.

BTW, I have used portions of this quote many times in class to encourage my students to think more like economists (i.e., become valuation experts) and less like bookkeepers (i.e., mindlessly working through a set of calculations).

“Two other potential sources of unreliable fair value measures are of direct interest to accounting researchers and accounting educators. Those two sources are intentional bias in inputs or judgements and lack of expertise. With regard to the first, ample research on earnings management and fraudulent financial reporting exists to demonstrate that management can, and sometimes does, purposefully introduce bias into reported measures. This source of measurement error is associated with perverse incentives, weak internal controls, failed governance and oversight and other causes that are not directly under the control of accounting standard setters. However, to the extent that reported fair value numbers are unreliable because of management-induced bias, the solution lies with changing the elements of the reporting environment (such as perverse reporting incentives and weak enforcement) that make it attractive and feasible to introduce bias.

“With regard to lack of expertise as a source of unreliable fair value measurements, I am not aware of research which documents the amount of inadvertent noncompliance generally, and reporting of unreliable fair values in particular, because of a lack of expertise among accountants. (FN 22) However, regardless of its pervasiveness, this source of unreliability offers a challenge to accounting education and accounting educators.

“My experience with teaching financial reporting, coupled with continuing conversations with accounting educators and reviews of accounting textbooks and other teaching materials, indicates that financial reporting is often taught as complex calculations that allocate transaction amounts, and not as measurement or valuation. For example, a textbook example or homework exercise provides the transaction amounts paid by an enterprise and requires the student to apply accounting reasoning and relevant accounting guidance to arrive at journal entries that allocate the (given) transaction amounts. Fair value measurements, however, require a different way of thinking and a different set of skills. I believe it would be inappropriate for accounting education to cede fair value measurement to valuation professionals – and I do not believe that doing so will necessarily enhance the reliability of fair value measurements in financial reports. Rather, I believe that the accounting profession will benefit if accounting education is shifted to provide students with skills and content knowledge that will equip them to deal with fair value measurements as accounting professionals, and that this approach has a better chance of improving the reliability of fair value measurements in the long run.”

FN 22: “An independent investigation of alleged faulty accounting at The Federal Home Loan Mortgage Corporation (‘Freddie Mac’) in the USA concluded that the alleged accounting errors resulted in part from a lack of accounting expertise among the firm’s accountants. The investigation concluded that the alleged accounting errors ‘often result[ed] from judgments and decisions by employees who lacked the expertise to appreciate the significance, gravity of, or rigor required by, the accounting decisions they were making’ (Baker Botts LLP, report dated 22 July 2003, p. 5).”

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